Which options to pre-select: OTM, ITM, or ATM?
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He's an options expert and his article below is a very valuable one that everyone should read! Please don't be shy and post your thoughts and opinions which options YOU prefer!
When trading options using short to medium term strategies, we're not looking to hold positions for a year, six months, or even three months. The idea is to enter and exit our trades within three to 40 days. When I surveyed participants about putting together a short to medium term option trad-ing strategy, the number one question I received was which options to preselect: I usually have to back track a little bit and review the highlights of short to medium term strategies. These are much different strategies than most traders and investors use.
Typically in-vestors and traders are thinking along the lines of being in a position for at least six months and maybe a few years or longer. They are in it for "the long haul. There's nothing wrong with these long term strategies. In fact, I think they're quite good for certain types of traders and investors. But, I have found, it simply doesn't fit my trad-ing style. I would rather see consistent high-percentage gains on low-risk, short-term trades. Here are the highlights of short to medium term option trading strategies, including my thoughts on pre-selecting options.
There are five steps in all. Unlike many traders, we don't want to scan hundreds of tickers a day. We don't have to. That's because we can use filters that automatically pull up the best candidates that might be ripe for an option trade.
Our filter chooses option candidates based on both fundamental and technical factors. And frankly, the fundamentals don't play much of a role in my trades. That's because fundamentals rarely impact a stock's price in the short term.
Many brokerage systems now allow you to program in at least parts of technical and fundamental filtering criteria. As part of our Trading Trainer member site, we've made custom filtering algorithms that specifically filter those tickers worth focusing on.
This saves our members time from having to try to fiddle with their brokerage systems. When all is said and done, there may be a dozen or so stocks on this pick list at any given time. This makes it possible to find great option trades in less than 30 minutes a day. After we've got our pick list, we invest some time doing in-depth analysis. Based on our criteria, we might pull out two or three or four stocks onto what I call our "hot list.
When -- and only when -- we have an underlying stock graduate to our hot list do we then preselect the associated option. When an option is "out of the money," it has not yet reached the strike price. The option has no intrinsic value, only potential value based on time remaining before expiration, expectations of underlying stock price movement, etc. An option that is "at the money" has reached the strike price.
An option that has reached its strike price can now be exercised. When an option is "in the money," that means it has gone beyond the strike price. Now the option has intrinsic value not based on speculation. It is helpful to know shorthand abbreviations like these because they are used so fre-quently.
So if you weren't familiar with these, now you are! It's important to know which option variable s you're trying to profit from. There's time decay, there's volatility movement, and there is the directional movement of the underlying stock. The effects of time decay and volatility actually add two dimensions to how an option price moves.
What I mean by this is that you can have an underlying stock price moving one direction in its price while the option moves the opposite simply because the effects of time decay and volatility are working opposite the directional movement of the underlying stock.
This is a difficult subject, so let me try to simplify it There's the intrinsic value and the time value. The intrinsic value has a one-to-one relationship with the underlying stock price. The time value depends not only on the underlying stock price, but also on time decay and volatility. The time value looks like a bell curve when plotted versus the underlying stock price with the highest point being when the underlying stock price and the option strike price are equal.
How high the bell curve gets depends, again, on time decay and volatility. Time decay causes the bell curve to drop at an exponentially increasing rate as you approach expi-ration. Volatility is probably the hardest variable to predict. An increase in volatility causes the bell curve to rise while a decrease in volatility causes it to fall. Understand-ing how volatility changes and by what degree it can affect the time value of an option premium are complex subject and outside the scope of this blog post.
Generally, the options we preselect are for strategies where we are either trying to profit from an option's time decay or from a directional move of the underlying stock or both.
In general, if you are trying to profit off time decay, we incorporate a strategy where we sell a near-term option that is deep enough in-the-money that the underlying stock price won't move and the option will expire worthless.
Some strategies like this include covered call writing and using vertical spreads. When profiting from a directional move, we buy far out-in-time options so the decay of time is minimal. We then trade options that are somewhere from at-the-money to in-the-money. If volatility change is probable, it's always smart to error by going deeper in-the-money. Of course if you are trying to profit from time decay and a directional move, a near-term at-the-money or in-the-money strategy that incorporates selling an option may be in or-der, but realize you are trying to manage two variables which actually creates four possible outcomes to think about.
Okay, with options preselected and while we're monitoring our hot list, we look for a set-up -- like a breakout -- that correlates to some kind of entry point. Entry signals we look for may include a gap down or a gap up on higher-than-average volume; an established trend with a small swing away from the trend followed by a big swing back into the trend; a "Short-Term Trend-Following" setup; or a variety of other signals.
Of course, we always look for follow-through to confirm the signal we're going to enter a trade on. If there is no follow-through and the price moves opposite of what we expectwe abandon the trade. Assuming we've been given a valid entry signal with follow-through, we enter the trade and then plan our exit.
And, in fact, my exit strategy is always in place before I ever en-ter a trade. Here's my general rule for our technical exit: So whatever signal produced the entry should also be the exit. Said another way, I leave through the same door I came in through.
This keeps it simple. Of these five steps I've shared with you, I believe Step 5 may be the most important of them all. How we exit a trade and the discipline we use to make our exits could make the difference between small gains and large gains, small losses and big losses. So those are the five basic steps I use to trade stock options short to medium term. If you'd like to learn my strategies more in-depth, you might want to consider checking out the Home Study Course with complimentary member site access.
What I haven't found in this article is the Stop Loss provisions un-mentioned. Are stops NOT desirable in such trades? I apologize that I didn't explicitly use the words stop loss in my blog post. To me, they are implied. And, in the post I wrote above, I stayed very high level for fear I might have published a whole other home study course as a guest blogger.
When I teach open position management, I teach that, in parallel, you must manage your technical stops, time stops and your stop losses. At a minimum, a stop loss provision will allow you to stay true to the money management limits you've extended yourself. If one enters a position on a price threshold crossing, they would want to exit on one as well.
Specifically, an exit on a price threshold crossing could very much be implemented using a stop loss. So, I contend that you and I are on the same page after all. My lack of being explicit on the use of stop losses in exits may have caused you to perceive otherwise. You do need to evaluate various profit-loss scenarios and understand how the outcomes of these scenarios play within your money management rules.
In the case of a covered call writing strategy, you are profiting if the underlying stock moves horizontally thanks to time decay. And, you are profiting if the underlying stock appreciates thanks to time decay and the increase of intrinsic value to a point. To keep from getting called out with an in-the-money option, and still take advantage of time decay, we can always buy back our option right before expiration.
It's good to note as well that the time value component of an option premium is at its highest when the option is at-the-money.
That means an option that is at-the-money will see the biggest change in price due to any number of variables changing including underlying stock price, time ticking away, and volatility. Although selling options at-the-money may seem to be the most profitable move, because of the option premium being so responsive to many different variables, it's also the most unpredictable outcome; the confidence we'll realize full profits goes down.
There are some details not clearly defined. Deep in-the money option will be exercised, not expire worthless. If it is a covered call, your stock will be called away.
Some profit-loss accounting required for this strategy, isn't it? I noticed that also. I think he meant "out of the money" if calls and in the money only if puts? It could work with either option type actually. It depends on your intention. What's most important is thinking through your end game with your preselected option, ahead of time and from that planning exactly what exit signals you're going to act on.